UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended March 31, 2005
OR
For the transition period from to
Commission file number 1-12675
KILROY REALTY CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification Number)
12200 W. Olympic Boulevard, Suite 200, Los Angeles, California 90064
(Address of principal executive offices)
(310) 481-8400
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
As of April 26, 2005, 28,894,505 shares of common stock, par value $.01 per share, were outstanding.
QUARTERLY REPORT FOR THE THREE MONTHS ENDED MARCH 31, 2005
TABLE OF CONTENTS
PART I—FINANCIAL INFORMATION
Item 1.
FINANCIAL STATEMENTS (unaudited)
Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004
Consolidated Statements of Operations for the Three Months Ended March 31, 2005 and 2004
Consolidated Statement of Stockholders’ Equity for the Three Months Ended March 31, 2005
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2005 and 2004
Notes to Consolidated Financial Statements
Item 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Item 4.
CONTROLS AND PROCEDURES
PART II—OTHER INFORMATION
LEGAL PROCEEDINGS
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
DEFAULTS UPON SENIOR SECURITIES
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Item 5.
OTHER INFORMATION
Item 6.
EXHIBITS
SIGNATURES
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except share data)
REAL ESTATE ASSETS (Notes 2 and 3):
Land and improvements
Buildings and improvements, net
Undeveloped land and construction in progress
Total real estate held for investment
Accumulated depreciation and amortization
Total real estate assets, net
CASH AND CASH EQUIVALENTS
RESTRICTED CASH
CURRENT RECEIVABLES, NET
DEFERRED RENT RECEIVABLES, NET
DEFERRED LEASING COSTS AND OTHER RELATED INTANGIBLES, NET
DEFERRED FINANCING COSTS, NET (Note 5)
PREPAID EXPENSES AND OTHER ASSETS
TOTAL ASSETS
LIABILITIES:
Secured debt
Unsecured senior notes
Unsecured line of credit (Note 4)
Accounts payable, accrued expenses and other liabilities (Note 7)
Accrued distributions (Note 13)
Rents received in advance, tenant security deposits and deferred revenue
Total liabilities
COMMITMENTS AND CONTINGENCIES
MINORITY INTERESTS (Note 6):
7.45% Series A Cumulative Redeemable Preferred unitholders
Common unitholders of the Operating Partnership
Total minority interests
STOCKHOLDERS’ EQUITY (Note 7):
Preferred stock, $.01 par value, 21,840,000 shares authorized, none issuedand outstanding
7.45% Series A Cumulative Redeemable Preferred stock, $.01 par value,1,700,000 shares authorized, none issued and outstanding
Series B Junior Participating Preferred stock, $.01 par value,400,000 shares authorized, none issued and outstanding
9.25% Series D Cumulative Redeemable Preferred stock, $.01 par value,1,000,000 shares authorized, none issued and outstanding
7.80% Series E Cumulative Redeemable Preferred stock, $.01 par value,1,610,000 shares authorized, issued and outstanding
7.50% Series F Cumulative Redeemable Preferred stock, $.01 par value,3,450,000 shares authorized, issued and outstanding
Common stock, $.01 par value, 150,000,000 shares authorized,28,894,505 and 28,548,597 shares issued and outstanding, respectively
Additional paid-in capital
Deferred compensation
Distributions in excess of earnings
Accumulated net other comprehensive income (Note 5)
Total stockholders’ equity
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except share and per share data)
Three Months Ended
March 31,
REVENUES (Note 9):
Rental income
Tenant reimbursements
Other property income
Total revenues
EXPENSES (Note 9):
Property expenses
Real estate taxes
Provision for bad debts
Ground leases
General and administrative expenses (Note 7)
Interest expense
Depreciation and amortization
Total expenses
OTHER INCOME
Interest and other income
Total other income
INCOME FROM CONTINUING OPERATIONS BEFORE MINORITY INTERESTS
MINORITY INTERESTS:
Distributions on Cumulative Redeemable Preferred units (Note 6)
Minority interest in earnings of Operating Partnership attributable to continuing operations
INCOME FROM CONTINUING OPERATIONS
DISCONTINUED OPERATIONS (Note 10)
Revenues from discontinued operations
Expenses from discontinued operations
Net gain on disposition of discontinued operations
Impairment loss on property held for sale
Minority interest in earnings of Operating Partnership attributable to discontinued operations.
Total income from discontinued operations
NET INCOME
PREFERRED DIVIDENDS
NET INCOME AVAILABLE FOR COMMON STOCKHOLDERS
Income from continuing operations per common share—basic (Note 11)
Income from continuing operations per common share—diluted (Note 11)
Net income per common share—basic (Note 11)
Net income per common share—diluted (Note 11)
Weighted average shares outstanding—basic (Note 11)
Weighted average shares outstanding—diluted (Note 11)
Dividends declared per common share
4
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(unaudited in thousands, except share and per share data)
BALANCE AT DECEMBER 31, 2004
Net income
Net other comprehensive income (Note 5)
Comprehensive income (Note 12)
Issuance of restricted stock (Note 7)
Exercise of stock options
Non-cash amortization of restricted stock
Repurchase of common stock (Note 7)
Redemption of common limited partnership units of the Operating Partnership (Note 6)
Stock option expense (Note 1)
Adjustment for minority interest (Note 1)
Preferred dividends
Common dividends declared($0.510 per share)
BALANCE AT MARCH 31, 2005
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities (including discontinued operations):
Depreciation and amortization of buildings and improvements and leasing costs
Net gain on disposition of operating properties
Minority interest in earnings of Operating Partnership
Non-cash amortization of restricted stock grants
Non-cash amortization of deferred financing costs
Amortization of above/below market rents, net
Increase (decrease) in provision for uncollectible tenant receivables
Increase in provision for uncollectible deferred rent receivables
Depreciation of furniture, fixtures and equipment
Other
Changes in assets and liabilities:
Current receivables
Deferred rent receivables
Deferred leasing costs
Prepaid expenses and other assets
Accounts payable, accrued expenses and other liabilities
Accrued distributions to Cumulative Redeemable Preferred unitholders
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Expenditures for operating properties
Expenditures for development and redevelopment projects and undeveloped land
Net proceeds received from dispositions of operating properties
Net cash provided by (used in) investing activities
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of secured debt
Net repayments on unsecured line of credit
Principal payments on secured debt
Distributions paid to common stockholders and common unitholders
Decrease (increase) in restricted cash
Financing costs
Proceeds from exercise of stock options
Distributions to preferred stockholders
Net cash used in financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest, net of capitalized interest of $1,950 and $1,816 at March 31, 2005 and 2004, respectively
Distributions paid to Cumulative Redeemable Preferred unitholders
NON-CASH TRANSACTIONS:
Accrual of distributions payable to common stockholders and common unitholders (Note 13)
Receipt of stock in connection with a lease termination fee
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Three Months Ended March 31, 2005 and 2004
(unaudited)
1. Organization and Basis of Presentation
Organization
Kilroy Realty Corporation (the “Company”) owns, operates and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). As of March 31, 2005, the Company’s stabilized portfolio of operating properties consisted of 82 office buildings (the “Office Properties”) and 48 industrial buildings (the “Industrial Properties”), which encompassed an aggregate of approximately 7.6 million and 4.5 million rentable square feet, respectively, and was 94.1% occupied. The Company’s stabilized portfolio of operating properties consists of all of the Office Properties and Industrial Properties and excludes properties currently under construction or “lease-up” properties.
The Company defines “lease-up” properties as properties recently developed or redeveloped by the Company that have not yet reached 95% occupancy and are within one year following substantial completion. Lease-up properties are reclassified to land and improvements and building and improvements from construction in progress on the consolidated balance sheets upon building shell completion. As of March 31, 2005 the Company had one redevelopment property encompassing approximately 241,600 rentable square feet, which was in the lease-up phase. In addition, as of March 31, 2005 the Company had two development properties under construction, which when completed are expected to encompass approximately 103,300 rentable square feet.
The Company owns its interests in all of its properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 88.6% general partnership interest in the Operating Partnership as of March 31, 2005. Kilroy Realty Finance, Inc., a wholly-owned subsidiary of the Company, is the sole general partner of the Finance Partnership and owns a 1.0% general partnership interest. The Operating Partnership owns the remaining 99.0% limited partnership interest of the Finance Partnership. The Company conducts substantially all of its development services through Kilroy Services, LLC (“KSLLC”), which is a wholly-owned subsidiary of the Operating Partnership. Unless otherwise indicated, all references to the Company include the Operating Partnership, the Finance Partnership, KSLLC and all wholly-owned subsidiaries of the Company.
Basis of Presentation
The consolidated financial statements of the Company include the consolidated financial position and results of operations of the Company, the Operating Partnership, the Finance Partnership, KSLLC and all wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
Net income after preferred distributions is allocated to the common limited partners of the Operating Partnership (“Minority Interest of the Operating Partnership”) based on their ownership percentage of the Operating Partnership. The common limited partner ownership percentage is determined by dividing the number of common units held by the Minority Interest of the Operating Partnership by the total common units outstanding. The issuance of additional shares of common stock or common units results in changes to the Minority Interest of the Operating Partnership percentage as well as the total net assets of the Company. As a result, all capital transactions result in an allocation between stockholders’ equity and the minority interest held by common unitholders of the Operating Partnership in the accompanying consolidated balance sheets to account for the change in the Minority Interest of the Operating Partnership ownership percentage as well as the change in total net assets of the Company.
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
The accompanying interim financial statements have been prepared by the Company’s management in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and in conjunction with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures required for annual financial statements have been condensed or excluded pursuant to SEC rules and regulations. Accordingly, the interim financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying interim financial statements reflect all adjustments of a normal and recurring nature which are considered necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the year ended December 31, 2005. These financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2004.
Reclassifications
Certain prior period amounts have been reclassified to conform to the current period’s presentation.
Recent Accounting Pronouncements
In December 2004, the FASB issued Statement 123 (revised), “Share-Based Payment” (“FAS 123(R)”). FAS 123(R) requires that all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. The new standard will be effective as of the beginning of the first fiscal year beginning after June 15, 2005. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial condition.
Stock Option Accounting
Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) prospectively, for all employee stock option awards granted or settled after January 1, 2002. Under the fair value recognition provisions of SFAS 123, total compensation expense related to stock options is determined using the fair value of the stock options on the date of grant. Total compensation expense is then recognized on a straight-line basis over the option vesting period.
8
Prior to 2002, the Company accounted for stock options issued under the recognition and measurement provisions of APB Opinion 25 “Accounting for Stock Issued to Employees and Related Interpretations.” The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period.
Net income available for common stockholders, as reported
Add: Stock option expense included in reported net income
Deduct: Total stock option expense determined under fair value recognition method for all awards
Pro forma net income available for common stockholders
Net income per common share:
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
2. Dispositions
Dispositions
During the three months ended March 31, 2005, the Company sold the following properties:
Address / City
Rentable
Square Feet
2501 Pullman/1700 Carnegie
Santa Ana, CA
525 North Brand
Glendale, CA
5115 North 27th Avenue
Phoenix, AZ
Total
These properties were sold through a portfolio transaction for an aggregate gross sales price of $38.7 million. The Company recorded a net gain of approximately $5.8 million in connection with the disposition. The Company used the net cash proceeds from the sale of these properties to fund its development programs and to repay borrowings under the Credit Facility (defined in Note 4). The net income and the net gain on disposition for these properties have been included in discontinued operations for the three months ended March 31, 2005 and 2004 (see Note 10).
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3. Redevelopment Projects
Stabilized Redevelopment Project
During the three months ended March 31, 2005, the Company added the following redevelopment project to the Company’s stabilized portfolio:
Address / Submarket / City
5717 Pacific Center Blvd.
Sorrento Mesa
San Diego, CA
4. Unsecured and Secured Debt
Unsecured Line of Credit
As of March 31, 2005, the Company had borrowings of $153.0 million outstanding under its revolving unsecured line of credit (the “Credit Facility”) and availability of approximately $272.0 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.00% and LIBOR plus 1.70% depending upon the Company’s leverage ratio at the time of borrowing (4.01% at March 31, 2005), and matures in October 2007 with an option to extend the maturity for one year. The fee for unused funds ranges from an annual rate of 0.20% to 0.30% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
Debt Covenants and Restrictions
The Credit Facility, the unsecured senior notes and certain other secured debt arrangements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive financial covenants include a maximum total debt to total assets ratio, a maximum total secured debt to total assets ratio, a minimum debt service coverage and fixed charge coverage ratios, minimum consolidated tangible net worth and a limit of development activities as compared to total assets. The Company was in compliance with all of its debt covenants at March 31, 2005.
Capitalized Interest and Loan Fees
Total interest and loan fees capitalized was $2.1 million for both the three months ended March 31, 2005 and 2004.
5. Derivative Financial Instruments
The following table sets forth the terms and fair market value of the Company’s derivative financial instruments at March 31, 2005:
Type of Instrument
Interest rate swap
Total included in deferred financing costs
10
In January 2005, the Company’s interest-rate swap agreement to fix LIBOR on $50 million of its variable-rate debt at 4.46% expired. The instruments described above have been designated as cash flow hedges. As of March 31, 2005, the balance in accumulated other net comprehensive income (“AOCI”) was approximately $1.1 million relating to the net increase in the fair market value of the derivative instruments since their inception. For the three months ended March 31, 2005 and 2004, the Company did not record any gains or losses attributable to cash flow hedge ineffectiveness since the terms of the Company’s derivative contracts and debt obligations were and are expected to continue to be effectively matched. Amounts reported in AOCI will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt.
6. Minority Interests
Minority interests represent the common and preferred limited partnership interests in the Operating Partnership. The Company owned an 88.6% and 87.2% general partnership interest in the Operating Partnership as of March 31, 2005 and 2004.
During the three months ended March 31, 2005, 269,249 common limited partnership units of the Operating Partnership were redeemed for shares of the Company’s common stock on a one-for-one basis. Neither the Company nor the Operating Partnership received any proceeds from the issuance of the common stock for the redemption of the common limited partnership units.
7. Stockholders’ Equity and Employee Incentive Plans
In February 2005, the Company’s Compensation Committee granted an aggregate of 101,112 restricted shares of common stock to certain executive officers and key employees. Compensation expense for the restricted shares is calculated based on the closing price per share of $41.35 on the February 23, 2005 grant date and is amortized on a straight-line basis over the performance and vesting periods. Of the shares granted, 18,139 vest at the end of a one-year period, 61,812 vest in equal annual installments over a two-year period and 21,161 vest in equal annual installments over a five-year period. The Company recorded approximately $0.3 million in compensation expense related to these restricted stock grants during the three months ended March 31, 2005 and 2004.
In March 2003, the Company’s Executive Compensation Committee approved a special long-term compensation program for the Company’s executive officers. The program provides for cash compensation to be earned at December 31, 2005 if the Company attains certain performance measures based on annualized total shareholder returns on an absolute and relative basis. The amount payable for the absolute component is based upon the amount by which the annualized total return to stockholders over the period exceeds 10%. The targets for the relative component require the Company to obtain an annualized total return to stockholders that is at or above the 70th percentile of annualized total return to stockholders achieved by members of a pre-defined peer group during the same three-year period, and includes additional incentives for annualized total return to stockholders that is at or above the 80th percentile. Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the New York Stock Exchange (“NYSE”) for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. Under the absolute portion of the plan, for every $1 change in the Company’s ten-day average closing stock price, the total payable over the three-year term of the plan changes by approximately $1.7 million. During the three months ended March 31, 2005 and 2004, the Company accrued approximately $1.7 million and $3.6 million, respectively, of compensation expense related to this plan, which is included in general and administrative expenses. The total amount accrued relating to the plan was $26.1 million as of March 31, 2005 which is included in accounts payable, accrued expenses and other liabilities.
11
During the three months ended March 31, 2005, the Company accepted the return, at the current quoted market price, of 41,119 shares of its common stock from certain key employees in accordance with the provisions of its incentive stock plan to satisfy minimum statutory tax-withholding requirements related to restricted shares that vested during this period.
8. Commitments and Contingencies
In January 2005, the Company paid $1.8 million pursuant to a court approved settlement agreement related to a lease termination that occurred in 2001. The amount was previously recorded as a charge to other property income during the third quarter of 2004.
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9. Segment Disclosure
The Company’s reportable segments consist of the two types of commercial real estate properties for which management internally evaluates operating performance and financial results: Office Properties and Industrial Properties. The Company also has certain corporate level activities including legal administration, accounting, finance and management information systems, which are not considered separate operating segments.
The Company evaluates the performance of its segments based upon Net Operating Income. Net Operating Income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, ground leases and provision for bad debts) and does not include interest and other income, interest expense, depreciation and amortization and corporate general and administrative expenses. There is no intersegment activity.
Office Properties:
Operating revenues(1)
Property and related expenses
Net Operating Income, as defined
Industrial Properties:
Total Reportable Segments:
Reconciliation to Consolidated Net Income:
Total Net Operating Income, as defined, for reportable segments
Other unallocated revenues:
Other unallocated expenses:
General and administrative expenses
Income from continuing operations before minority interests
Minority interests attributable to continuing operations
Income from discontinued operations
Net income available to common stockholders
13
10. Discontinued Operations
In accordance with SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the net income and the net gain or loss on dispositions of operating properties sold or classified as held for sale are reflected in the consolidated statement of operations as discontinued operations for all periods presented. For the three months ended March 31, 2005 and 2004, discontinued operations included the net income and the net gain on sale of three office buildings and one industrial building sold during the three months ended March 31, 2005 (see Note 2). For the three months ended March 31, 2004, discontinued operations also included the net income, the impairment loss and net gain or loss on sale of one office property and one industrial property sold in 2004. The following table summarizes the income and expense components that comprise discontinued operations for the three months ended March 31:
Three MonthsEnded
REVENUES:
EXPENSES:
Income from discontinued operations before minority interests
Minority interest in earnings of Operating Partnership attributable to discontinued operations
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11. Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income by the sum of the weighted-average number of common shares outstanding for the period plus the number of common shares issuable assuming the exercise of all dilutive securities. The Company does not consider common units of the Operating Partnership to be dilutive since any issuance of shares of common stock upon the redemption of the common units would be on a one-for-one basis and would not have any effect on diluted earnings per share. The following table reconciles the numerator and denominator of the basic and diluted per-share computations for net income.
Numerator:
Net income from continuing operations before preferred dividends
Discontinued operations
Net income available for common stockholders—numerator for basic and diluted earnings per share
Denominator:
Basic weighted-average shares outstanding
Effect of dilutive securities-stock options and restricted stock
Diluted weighted-average shares and common share equivalents outstanding
Basic earnings per share:
Net income available for common stockholders
Diluted earnings per share:
At March 31, 2005, Company employees and directors did not hold any options to purchase shares of the Company’s common stock that were antidilutive to the diluted earnings per share computation.
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12. Comprehensive Income
Comprehensive income for the three months ended March 31, 2005 and 2004 consisted of net income plus changes in the fair market value of cash flow hedges that were properly not reflected in the consolidated statements of operations. The components of comprehensive income are as follows:
Net other comprehensive income (loss):
Unrealized derivative gain (loss) on cash flow hedges, net
Comprehensive income
13. Subsequent Events
On April 15, 2005, aggregate distributions of approximately $16.6 million were paid to common stockholders and common unitholders of record on March 31, 2005.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion relates to the consolidated financial statements of the Company and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. Statements contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical facts may be forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. Some of the information presented is forward-looking in nature, including information concerning projected future occupancy rates, rental rate increases, project development timing and investment amounts. Although the information is based on the Company’s current expectations, actual results could vary from expectations stated in this report. Numerous factors will affect the Company’s actual results, some of which are beyond its control. These include the timing and strength of regional economic growth, the strength of commercial and industrial real estate markets, competitive market conditions, future interest rate levels and capital market conditions. You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. The Company assumes no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise, except to the extent the Company is required to do so in connection with its ongoing requirements under federal securities laws to disclose material information. For a discussion of important risks related to the Company’s business and an investment in its securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information contained in this report, see the discussion under the caption “Business Risks” in the Company’s annual report on Form 10-K for the year ended December 31, 2004 and under the caption “Factors That May Influence Future Results of Operations” below. In light of these risks, uncertainties and assumptions, the forward-looking events contained in this report may not occur.
Overview and Background
Kilroy Realty Corporation (the “Company”) owns, operates, and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). The Company owns its interests in all of its properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 88.6% and 87.2% general partnership interest in the Operating Partnership as of March 31, 2005 and 2004, respectively.
Factors That May Influence Future Results of Operations
Rental income. The amount of net rental income generated by the Company’s properties depends principally on its ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties and space available from unscheduled lease terminations. The amount of rental income generated by the Company also depends on its ability to maintain or increase rental rates in its submarkets. Negative trends in one or more of these factors could adversely affect the Company’s rental income in future periods.
Rental rates. For leases that commenced during the three months ended March 31, 2005, the change in rental rate was an increase of 10.5% on a GAAP basis, and a decrease of 2.8% on a cash basis. The change in rental rate on a cash basis is calculated as the change between the initial stated rent for a new or renewed lease and the ending stated rent for the expiring lease for the same space, whereas the change in rental rate on a GAAP basis compares the average rents over the term of the lease for each lease. Both calculations exclude leases for which the space was vacant longer than one year. Management believes that the average rental rates for its properties are approximately at the current average quoted market rates, although individual properties within any particular submarket presently may be leased above or below the current quoted market rates within that submarket. The Company cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current quoted market rates.
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Scheduled lease expirations. In addition to the 705,500 square feet of currently available space in the Company’s stabilized portfolio, leases representing approximately 4.7% and 10.2% of the leased square footage of the Company’s stabilized portfolio are scheduled to expire during the remainder of 2005 and 2006, respectively. The leases scheduled to expire during the remainder of 2005 and the leases scheduled to expire in 2006 represent approximately 1.0 million square feet of office space, or 11.1% of the Company’s total annualized base rent, and 0.6 million square feet of industrial space, or 2.5% of the Company’s total annualized base rent, respectively. Management believes that the average rental rates for leases scheduled to expire during the remainder of 2005 are approximately at the current average quoted market rates. The Company’s ability to release available space depends upon the market conditions in the specific submarkets in which the Properties are located.
Submarket Information
Los Angeles County. There have been modest signs of improvement in market conditions in the overall Los Angeles County region during the last two years based on third-party reports of positive absorption and decreased levels of direct vacancy as well as an increased level of interest in leasing opportunities at the Company’s properties. Most notable have been the improvements seen in the West Los Angeles and Long Beach submarkets. Conversely, the El Segundo submarket remains the Company’s most significant leasing challenge as management continues to see only mild signs of improvement in this region. At March 31, 2005, the Company’s Los Angeles stabilized office portfolio was 94% occupied with approximately 170,500 vacant rentable square feet as compared to 91% occupied with approximately 257,100 vacant rentable square feet at December 31, 2004. As of March 31, 2005, leases representing an aggregate of approximately 118,000 and 367,500 rentable square feet are scheduled to expire during the remainder of 2005 and 2006, respectively, in this region.
The Los Angeles stabilized portfolio includes an office building that was developed by the Company that has not yet reached stabilized occupancy. The building, which is located in a two-building office complex in the El Segundo submarket, was added to the stabilized portfolio in 2003 since one year had passed following substantial completion. This building encompasses approximately 133,300 rentable square feet and was approximately 56% occupied as of March 31, 2005 compared to 37% as of December 31, 2004. The Company is currently in lease negotiations on an additional 38,000 square feet of space in this building, which, if executed, will increase occupancy to 84% from 56% as of March 31, 2005. Within the same complex in El Segundo, the Company has one office redevelopment project encompassing approximately 241,600 rentable square feet. This project was in the lease-up phase and was 19% leased as of March 31, 2005.
San Diego County. San Diego County remains one of the strongest markets in Southern California real estate based on third-party reports of positive absorption, increased rental rates and growing tenant demand. The Company continues to expand its presence in this market by aggressively seeking development opportunities in the region. In March 2005, the Company committed to develop a four-building office complex, which when complete will encompass an aggregate of approximately 466,000 rentable square feet. The Company has pre-leased three of the four buildings, or 78% of the rentable square feet, to a single tenant. See additional information under the caption “—Recent Information Regarding Significant Tenants—Intuit, Inc.” The Company also commenced construction on the third phase of a development project in July 2004, which when complete will encompass an aggregate of approximately 103,000 rentable square feet. This development project was not leased as of March 31, 2005. See additional information regarding the Company’s development projects under the caption “—Development and redevelopment programs.”
As of March 31, 2005, the Company’s San Diego stabilized office portfolio was 94% occupied with approximately 204,000 vacant rentable square feet compared to 97% occupied with approximately 102,300 vacant rentable square feet as of December 31, 2004. The decrease in occupancy is primarily attributable to one redevelopment project, encompassing approximately 68,000 rentable square feet, that was previously in the lease-up phase and was added to the stabilized portfolio during the first quarter of 2005 since one year had passed following substantial completion. This project has not been leased as of March 31, 2005. Leases representing an
18
aggregate of approximately 130,000 and 210,000 rentable square feet are scheduled to expire during the remainder of 2005 and 2006, respectively in this region.
Orange County. As of March 31, 2005, the Company’s Orange County properties were 98% occupied with approximately 73,100 vacant rentable square feet. As of March 31, 2005, leases representing an aggregate of approximately 217,000 and 358,700 rentable square feet were scheduled to expire during the remainder of 2005 and 2006, respectively, in this region.
Sublease space. Of the Company’s leased space at March 31, 2005, approximately 420,300 rentable square feet, or 3.5%, of the square footage in the Company’s stabilized portfolio was available for sublease, as compared to 435,200 rentable square feet, or 3.5% at December 31, 2004. Of the 3.5% of available sublease space in the Company’s stabilized portfolio as of March 31, 2005, approximately 2.9% was vacant space and the remaining 0.6% was occupied. Approximately 74% of the available sublease space as of March 31, 2005 is located in the Orange County submarket. Of the approximately 420,300 rentable square feet available for sublease at March 31, 2005, approximately 18,200 and 2,500 rentable square feet represents leases scheduled to expire during the remainder of 2005 and 2006, respectively.
Negative trends or other events that impair the Company’s ability to renew or release space and its ability to maintain or increase rental rates in its submarkets could have an adverse effect on the Company’s future financial condition, results of operations and cash flows.
Recent Information Regarding Significant Tenants
The Boeing Company. As of March 31, 2005, the Company’s largest tenant, The Boeing Company, leased an aggregate of approximately 831,300 rentable square feet of office space under seven separate leases, representing approximately 5.8% of the Company’s total annual base rental revenues. In April 2005, The Boeing Company extended, renewed or otherwise modified three of its existing leases. It extended one lease, which was scheduled to expire in January 2006, at a building located in El Segundo, encompassing approximately 101,000 rentable square feet. The extended lease expires in January 2007 and can be terminated by either party with 60-days advanced notice no earlier than April 30, 2006. The Boeing Company also renewed one lease at a building located in Anaheim, encompassing approximately 65,500 rentable square feet. The lease, which was originally scheduled to expire in October 2005, was extended through October 2010. In addition, an agreement was signed for a lease in Long Beach that was scheduled to expire in September 2005, whereby The Boeing Company will continue to pay rent on its lease, which encompasses approximately 43,600 rentable square feet, through May 31, 2005. Effective June 1, 2005 another company will take possession and begin paying rent on approximately 28,100 rentable square feet that is currently leased to The Boeing Company. For the period June 1, 2005 through September 30, 2005 The Boeing Company will continue to occupy and pay rent on the remaining approximately 15,500 rentable square feet. Furthermore, one lease, encompassing approximately 211,100 rentable square feet, is scheduled to expire in December 2007; however, under the terms of the lease, The Boeing Company has the right to terminate this lease on December 31, 2006 by giving the Company written notice one year in advance. The other three leases are scheduled to expire at various dates between August 2005 and March 2009.
Intuit Inc. As of March 31, 2005, Intuit, Inc. (“Intuit”), the Company’s sixth largest tenant, leased an aggregate of approximately 264,000 rentable square feet of office space under three separate leases, representing approximately 2.2% of the Company’s total annual base rental revenues. In March 2005, the Company executed a 10-year lease agreement with Intuit for approximately 365,000 rentable square feet. Under this agreement, Intuit will lease three of the four buildings in an office complex that the Company has committed to develop in the I-56 Corridor submarket in San Diego County. See additional information regarding the Company’s development projects under the caption “—Development and redevelopment programs.” The agreement also provides Intuit with the option to lease the fourth building. One of the earlier leases, encompassing approximately 212,000 rentable square feet, is scheduled to expire in April 2007. In connection with the new lease agreement, Intuit has the option to remain in approximately 141,000 rentable square feet of this space until it can occupy the new
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buildings, which is expected to be in the third quarter of 2007. In addition, Intuit has the option to extend this lease for the remaining 71,000 rentable square feet for up to two years. This second option must be exercised by January 1, 2006. The other two leases, which are in the Long Beach and Calabasas submarkets and encompass approximately 49,000 and 3,000 rentable square feet, are scheduled to expire in July 2014 and December 2005, respectively. Upon commencement of the new San Diego lease, Intuit is projected to become the Company’s largest tenant based on its percentage of the Company’s total annual base rent.
Development and redevelopment programs. Management believes that a significant portion of the Company’s potential growth over the next several years will continue to come from its development pipeline. During 2002 and 2003, the Company scaled back its development activity as result of the economic environment and its impact on the Company’s ability to lease projects within budgeted timeframes. However, as San Diego County remains one of the strongest market in Southern California, the Company has continued to aggressively seek development opportunities in the region. In March 2005, the Company committed to develop a four-building office complex in the I-56 Corridor submarket. The Company has pre-leased three of the four buildings, or 78% of the rentable square feet, to a single tenant and expects to complete the project by the third quarter of 2007. The project has a total estimated investment of $145 million and will encompass an aggregate of approximately 466,000 rentable square feet. See additional information under the caption “—Recent Information Regarding Significant Tenants—Intuit, Inc.” In addition, the Company commenced construction in July 2004 on the third phase of its Innovation Corporate Center, which is located in the San Diego County I-15 Corridor submarket. The first two phases of this development project, which encompass an aggregate of approximately 289,000 rentable square feet, are 100% leased. The third phase will include two office buildings and will encompass an aggregate of approximately 103,000 rentable square feet and has a total estimated investment of approximately $23 million. The Company does not currently have any lease commitments for these buildings as of March 31, 2005. However, management believes the prospects of leasing the project are positive given that the number of businesses actively seeking new office space in the region continues to grow.
The Company also owns approximately 41.6 acres of undeveloped land upon which the Company currently expects to develop an aggregate of approximately 0.8 million rentable square feet of office space within the next three to five years. All of the Company’s undeveloped land is located in San Diego County. See additional information regarding the Company’s development portfolio under the caption “Development and Redevelopment” in this report.
Management believes that another source of the Company’s potential growth over the next several years will come from redevelopment opportunities within its existing portfolio. Redevelopment efforts can achieve similar returns to new development with reduced entitlement risk and shorter construction periods. The Company’s redevelopment portfolio currently consists of an office building in El Segundo for which the Company performed extensive interior refurbishments. The building had previously been occupied by a single tenant for approximately 30 years. This project, which encompasses approximately 241,600 rentable square feet, was completed in 2004 and is expected to be added to the stabilized portfolio in the third quarter of 2005. As of March 31, 2005, this property was 19% leased. See additional information regarding the Company’s in-process redevelopment portfolio under the caption “Development and Redevelopment” in this report. Depending on market conditions, the Company will continue to pursue future redevelopment opportunities in its strategic submarkets where no land available for development exists.
The Company has a proactive planning process by which it continually evaluates the size, timing and scope of its development and redevelopment programs and, as necessary, scales activity to reflect the economic conditions and the real estate fundamentals that exist in the Company’s strategic submarkets. However, the Company may be unable to lease committed development or redevelopment properties at expected rental rates or within projected timeframes or complete projects on schedule or within budgeted amounts, which could adversely affect the Company’s financial condition, results of operations and cash flows.
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Other Factors. The Company’s operating results are and may continue to be affected by uncertainties and problems associated with the deregulation of the utility industry in California since 95.6% of the total rentable square footage of the Company’s stabilized portfolio is located in California. Energy deregulation has resulted in higher utility costs in some areas of the state and intermittent service interruptions. In addition, primarily as a result of the events of September 11, 2001, the Company’s annual insurance costs increased across its portfolio by approximately 14% during 2002, approximately 11% during 2003, approximately 12% during 2004, and approximately 3% year to date in 2005. As of the date of this report, the Company had not experienced any material effects arising from either of these issues.
In addition, the California State legislature is currently evaluating split tax roll legislation, which if enacted, could have a material effect on the Company’s operating results. If the current initiative is passed, the tax rate on commercial property in California would increase, which would result in significant increases in real estate taxes for the Company’s properties located in California.
Incentive Compensation. The Company has long-term incentive compensation programs that provide for cash and stock compensation to be earned by the Company’s senior officers if the Company attains certain performance measures that are based on annualized shareholder returns on an absolute and a relative basis as well as certain other financial, operating and development targets. As a result, accrued incentive compensation in future periods is affected by the ten-day average closing price per share of the Company’s common stock at the end of each quarter. Future increases or decreases in the price per share of the Company’s common stock and the resultant cumulative annualized shareholder return calculations will cause an increase or decrease to general and administrative expenses and a corresponding decrease or increase to net income available to common shareholders. Under the absolute component of a special long-term plan for the Company’s executive officers, every $1 change in the Company’s ten-day average closing stock price at the end of each period equates to an approximate $1.7 million change in the total amount payable at the end of the three-year term of the plan (see Note 7 to the Company’s consolidated financial statements for further discussion about the program). Management cannot predict the amounts that will be ultimately recorded in future periods related to these programs since they are significantly influenced by the Company’s stock price and market conditions.
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Results of Operations
As of March 31, 2005, the Company’s stabilized portfolio was comprised of 82 office properties (the “Office Properties”) encompassing an aggregate of approximately 7.6 million rentable square feet, and 48 industrial properties (the “Industrial Properties,” and together with the Office Properties, the “Properties”), encompassing an aggregate of approximately 4.5 million rentable square feet. The Company’s stabilized portfolio of operating properties consists of all the Properties, and excludes properties recently developed or redeveloped by the Company that have not yet reached 95.0% occupancy and are within one year following substantial completion (“lease-up” properties) and projects currently under construction.
As of March 31, 2005, the Office and Industrial Properties represented 84.7% and 15.3%, respectively, of the Company’s annualized base rent. For the three months ended March 31, 2005, average occupancy in the Company’s stabilized portfolio was 94.3% compared to 90.8% for the three months ended March 31, 2004. As of March 31, 2005, the Company had approximately 705,500 rentable square feet of vacant space in its stabilized portfolio compared to 1,103,400 rentable square feet as of March 31, 2004.
The following table reconciles the changes in the rentable square feet in the Company’s stabilized portfolio of operating properties from March 31, 2004 to March 31, 2005. Rentable square footage in the Company’s portfolio of stabilized properties remained consistent at approximately 12.0 million rentable square feet at March 31, 2005, compared to March 31, 2004.
Square
Feet
Total at March 31, 2004
Acquisitions
Properties added from the Development Portfolio
Properties added from the Redevelopment Portfolio
Dispositions(1)(2)
Remeasurement
Total at March 31, 2005
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Comparison of the Three Months Ended March 31, 2005 to the Three Months Ended March 31, 2004
Management internally evaluates the operating performance and financial results of its portfolio based on Net Operating Income for the following segments of commercial real estate property: Office Properties and Industrial Properties. The Company defines Net Operating Income as operating revenues from continuing operations (rental income, tenant reimbursements and other property income) less property and related expenses from continuing operations (property expenses, real estate taxes, provision for bad debts and ground leases). The Net Operating Income segment information presented within this Management’s Discussion and Analysis consists of the same Net Operating Income segment information disclosed in Note 9 of the Company’s consolidated financial statements in accordance with Statement of Financial Accounting Standards No. 131 “Disclosures about Segments of an Enterprise and Related Information.” The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income for the three months ended March 31, 2005 and 2004.
Three Months
Ended
Net Operating Income, as defined:
Office Properties
Industrial Properties
Total portfolio
Net Operating Income, as defined for reportable segments
Other expenses:
Income from continuing operations before minority interest
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Rental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the Net Operating Income for the Office Properties and for the Industrial Properties for the three months ended March 31, 2005 and 2004.
Operating revenues:
Property and related expenses:
Total revenues from Office Properties increased $6.1 million, or 13.8%, to $50.2 million for the three months ended March 31, 2005 compared to $44.1 million for the three months ended March 31, 2004. Rental income from Office Properties increased $6.2 million, or 15.8%, to $45.3 million for the three months ended March 31, 2005 compared to $39.1 million for the three months ended March 31, 2004. Rental income generated by the Core Office Portfolio increased $2.6 million, or 7.2%, for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004. The increase in the Core Office Portfolio is primarily due to an increase in occupancy. Average occupancy in the Core Office Portfolio increased 5.6% to 94.6% for the three months ended March 31, 2005 compared to 89.0% for the same period in 2004. The remaining $3.6 million increase in rental income was attributable to a $2.3 million increase in rental income generated by the two office buildings acquired by the Company in the fourth quarter of 2004 (the “Office Acquisition Properties”), a $0.9 million increase in rental income generated by the office redevelopment properties that were completed during 2004 (the “Office Redevelopment Properties”) and a $0.4 million increase in rental income generated by the office development property that was added to the stabilized portfolio in the third quarter of 2004 (the “Office Development Property”).
Tenant reimbursements from Office Properties increased $0.3 million, or 6.5%, to $4.7 million for the three months ended March 31, 2005 compared to $4.4 million for the three months ended March 31, 2004. Tenant reimbursements generated by the Core Office Portfolio remained consistent at $4.4 million for the three months ended March 31, 2005 compared to the same period in 2004. An increase of $0.2 million in tenant reimbursements is attributable to the Office Redevelopment Properties and an increase of $0.1 million in tenant reimbursements is attributable to the Office Development Property. Other property income from Office Properties decreased approximately $0.4 million, or 72.3%, to $0.1 million for the three months ended March 31, 2005 compared to $0.5 million for the three months ended March 31, 2004. Other property income for both periods consisted primarily of lease termination fees and other related income associated with early lease terminations within the Core Office Portfolio.
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Total expenses from Office Properties increased $2.4 million, or 20.4%, to $14.0 million for the three months ended March 31, 2005 compared to $11.6 million for the three months ended March 31, 2004. Property expenses from Office Properties increased $0.9 million, or 12.0%, to $8.8 million for the three months ended March 31, 2005 compared to $7.9 million for the three months ended March 31, 2004. An increase of $0.5 million, or 6.5%, was generated by the Core Office Portfolio. This increase was primarily attributable to an increase in property management expenses, janitorial and other contract services related to the increase in occupancy. Of the remaining increase of $0.4 million in property expenses, $0.3 million was attributable to the Office Acquisition Properties and $0.1 million was attributable to both the Office Development Property and the Office Redevelopment Properties. Real estate taxes from Office Properties increased $0.5 million, or 16.5%, for the three months ended March 31, 2005 as compared to the same period in 2004. Real estate taxes for the Core Office Portfolio increased $0.2 million, or 5.9%, for the three months ended March 31, 2005 compared to the three months ended March 31, 2004. The remaining $0.3 million increase in real estate taxes was due to a $0.2 million increase in property taxes generated by the Office Acquisition Properties and a $0.1 million increase in property taxes generated by the Office Redevelopment Properties. The provision for bad debts from Office Properties increased $0.8 million, or 340.2%, for the three months ended March 31, 2005 compared to the three months ended March 31, 2004. During the three months ended March 31, 2005, the Company increased its reserves for certain tenants on the Company’s watchlist that the Company closely monitors because the tenant may be experiencing financial difficulties or they are consistently late in paying outstanding balances. The Company evaluates its reserve levels on a quarterly basis. Ground lease expense for Office Properties increased $0.1 million, or 22.7%, to $0.4 million for the three months ended March 31, 2005 compared to $0.3 million for the three months ended March 31, 2004.
Net Operating Income, as defined, from Office Properties increased $3.7 million, or 11.4%, to $36.2 million for the three months ended March 31, 2005 compared to $32.5 million for the three months ended March 31, 2004. Of this increase, $0.8 million was generated by the Core Office Portfolio due to an increase in occupancy in this portfolio as mentioned above. Of the remaining increase of $2.9 million, $1.6 million was generated by the Office Acquisition Properties, $0.9 million was generated by the Office Redevelopment Properties and $0.4 million was generated by the Office Development Property.
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Total revenues from Industrial Properties decreased $0.1 million to $9.1 million for the three months ended March 31, 2005 as compared to $9.2 million for the three months ended March 31, 2004. Rental income from Industrial Properties increased $0.2 million, or 2.2%, to $8.0 million for the three months ended March 31, 2005 compared to $7.8 million for the three months ended March 31, 2004. This increase was primarily due to an increase in occupancy. Average occupancy in the Industrial Properties increased 1.0% to 94.7% for the three months ended March 31, 2005 as compared to 93.7% for the three months ended March 31, 2004.
Tenant reimbursements from Industrial Properties increased $0.1 million, or 15.6%, to $1.0 million for the three months ended March 31, 2005 compared to $0.9 million for the three months ended March 31, 2004. This increase is primarily due to an increase in occupancy in this portfolio. Other property income from Industrial Properties decreased $0.4 million, or 83.2%, to $0.1 million for the three months ended March 31, 2005 compared to $0.5 million for the three months ended March 31, 2004. Other Property Income for both periods consisted primarily of lease termination fees.
Total expenses from Industrial Properties increased $0.1 million, or 7.3%, to $1.4 million for the three months ended March 31, 2005 compared to $1.3 million for the three months ended March 31, 2004. Property expenses from Industrial Properties remained consistent at approximately $0.6 million during the three months ended March 31, 2005 compared to the same period in 2004. Real estate taxes from Industrial Properties remained consistent at approximately $0.7 million during the three months ended March 31, 2005 compared to the same period in 2004. The provision for bad debts increased by $0.1 million for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income, as defined, from Industrial Properties decreased $0.2 million, or 2.4% to $7.7 million for the three months ended March 31, 2005 compared to $7.9 million for the three months ended March 31, 2004.
Non-Property Related Income and Expenses
Interest and other income decreased approximately $0.2 million, or 81.4%, to $0.1 million for the three months ended March 31, 2005 compared to $0.3 million for the three months ended March 31, 2004. The decrease is primarily due to a $0.1 million net realized gain from the sale of stock that the Company received in March 2004 in satisfaction of a creditor’s claim under a lease that was terminated early. In addition, during the three months ended March 31, 2004, the Company recorded $0.1 million in non-recurring interest earned in connection with a reimbursement of prior year supplemental property taxes.
General and administrative expenses decreased $1.7 million, or 21.7%, to $6.0 million for the three months ended March 31, 2005 compared to $7.7 million for the three months ended March 31, 2004. The decrease was primarily due to a $1.9 million decrease in the charge for accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executive officers for which the amount payable under the plan is based on the Company’s absolute and relative shareholder returns (see Note 7 to the Company’s consolidated financial statements for further discussion about the program). Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the NYSE for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. The decrease in the charge for accrued incentive compensation is due to the decline in the share price of the Company’s stock at the end of the first quarter of 2005 as compared to December 31, 2004 and the resultant cumulative adjustment recorded as of March 31, 2005 for the change in estimated compensation expense attributable to prior periods. The amounts recorded in future periods related to this plan will increase and decrease as the ten-day average price per share of the Company’s common stock at the end of each period increases or decreases.
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Net interest expense increased $0.4 million, or 4.5%, to $9.6 million for the three months ended March 31, 2005 compared to $9.2 million for the three months ended March 31, 2004. Gross interest and loan fee expense, before the effect of capitalized interest and loan fees, increased $0.4 million, or 3.8%, to $11.7 million for the three months ended March 31, 2005 compared to $11.3 million for the three months ended March 31, 2004. Total capitalized interest and loan fees were $2.1 million for both the three months ended March 31, 2005 and the three months ended March 31, 2004.
Depreciation and amortization increased $2.5 million, or 18.6%, to $16.2 million for the three months ended March 31, 2005 compared to $13.7 million for the three months ended March 31, 2004. An increase of $1.0 million and $0.1 million was generated by the Core Office Portfolio and the Core Industrial Portfolio, respectively. These increases were mainly attributable to expenditures incurred subsequent to March 31, 2004 for capital and tenant improvements. Of the remaining $1.4 million increase in depreciation and amortization, $1.1 million was generated by the Office Acquisition Properties, $0.2 million was generated by the Office Redevelopment Properties and $0.1 million was generated by the Office Development Property.
Building and Lease Information
The following tables set forth certain information regarding the Company’s Office Properties and Industrial Properties at March 31, 2005:
Occupancy by Segment Type
Los Angeles
Orange County
San Diego
Total Office
Total Industrial
Total Portfolio
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Lease Expirations by Segment Type
Year of Lease Expiration
Annual BaseRent UnderExpiringLeases
(in 000’s)(3)
Remaining 2005(4)
2006
2007
2008
2009
2010
Leasing Activity by Segment Type
Square Feet(1)
For the Three Months Ended March 31, 2005:
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Development and Redevelopment
The following tables set forth certain information regarding the Company’s in-process and committed office development and redevelopment projects as of March 31, 2005. See further discussion regarding the Company’s projected development and redevelopment trends under the caption “Factors That May Influence Future Results of Operations—Development and redevelopment programs.”
Development Projects
Project Name / Submarket / City
Feet UponCompletion
Costs
as ofMarch 31,2005
Percent
Leased
Projects Under Construction:
15227 Avenue of ScienceI-15 CorridorSan Diego, CA
15253 Avenue of ScienceI-15 CorridorSan Diego, CA
Subtotal
Committed Projects:
Santa Fe Summit56 CorridorSan Diego, CA
Total In-Process and Committed Projects:
Redevelopment Projects
Project Name /Submarket / City
Pre- andPost-Redevelop-
ment Type
ExistingInvest-
ment(2)
EstimatedRedevel-
opmentCosts(3)
Total Costs
PercentLeased
Projects in Lease-Up:
909 Sepulveda Blvd.El Segundo, CA
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Liquidity and Capital Resources
Current Sources of Capital and Liquidity
The Company seeks to create and maintain a capital structure that allows for financial flexibility and diversification of capital resources. The Company’s primary source of liquidity to fund distributions, debt service, leasing costs and capital expenditures is net cash from operations. The Company’s primary sources of liquidity to fund development and redevelopment costs, potential undeveloped land and property acquisitions, temporary working capital and unanticipated cash needs are the Company’s $425 million unsecured revolving line of credit, proceeds received from the Company’s disposition program and construction loans. As of March 31, 2005, the Company’s total debt as a percentage of total market capitalization (presented under—Factors That May Influence Future Sources of Capital and Liquidity) was 33.8%. As of March 31, 2005, the Company’s total debt plus preferred equity as a percentage of total market capitalization was 42.4%.
Factors That May Influence Future Sources of Capital and Liquidity
The Credit Facility, unsecured senior notes, and certain other secured debt agreements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive covenants include a maximum total debt to total assets ratio, a maximum total secured debt to total assets ratio, minimum debt service coverage and fixed charge coverage ratios, a minimum consolidated tangible net worth and a limit of development activities as compared to total assets. Non-compliance with one or more of the covenants and restrictions could result in the full or partial principal balance of the associated debt becoming immediately due and payable. The Company was in compliance with all its covenants at March 31, 2005.
The following table sets forth certain information with respect to the Company’s aggregate debt composition at March 31, 2005 and December 31, 2004:
Secured vs. unsecured:
Secured
Unsecured
Fixed-rate vs. variable-rate:
Fixed-rate(1)(2)(3)
Variable-rate
Total debt
Total debt including loan fees
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Following is the Company’s total market capitalization as of March 31, 2005:
Debt:
Unsecured line of credit
Equity:
7.450% Series A Cumulative Redeemable Preferred Units(1)
7.800% Series E Cumulative Redeemable Preferred Stock(2)
7.500% Series F Cumulative Redeemable Preferred Stock(2)
Common units outstanding(3)
Common shares outstanding(3)
Total equity
Total Market Capitalization
Contractual Obligations
The following table provides information with respect to the maturities and scheduled principal repayments of the Company’s secured debt and Credit Facility and scheduled interest payments of the Company’s fixed-rate debt and interest-rate swap agreements at March 31, 2005 and provides information about the minimum commitments due in connection with the Company’s ground lease obligations and capital commitments at March 31, 2005. The table does not reflect available maturity extension options.
Principal payments—secured debt
Principal payments—Credit Facility(1)
Principal payments—unsecured senior notes
Interest payments—fixed-rate debt(2)
Interest payments—interest-rate swaps(2)(3)
Ground lease obligations(4)
Capital commitments(5)
As of March 31, 2005, 85.6% of the Company’s debt was contractually fixed or constructively fixed through interest-rate swap agreements. The information in the table above reflects the Company’s projected interest rate obligations for these fixed-rate payments based on the contractual interest rates, interest payment dates and scheduled maturity dates. The remaining 14.4% of the Company’s debt bears interest at variable rates and the variable interest rate payments are based on LIBOR plus a spread that ranges from 1.00% to 1.70%. The interest payments on the Company’s variable-rate debt have not been reported in the table above because management cannot reasonably determine the future interest obligations on its variable-rate debt as management cannot predict what LIBOR rates will
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be in the future. As of March 31, 2005, one-month LIBOR was 2.87%. See additional information regarding the Company’s debt and derivative instruments under Item 3: Quantitative and Qualitative Disclosures about Market Risk.
Capital Commitments
As of March 31, 2005, the Company had two development projects under construction with a total estimated investment of $23 million. The Company also had one redevelopment project that was in the lease-up phase with a total estimated investment of $69 million. In addition, in March 2005, the Company committed to develop a four-building office complex, which is 78% pre-leased to a single tenant. The Company expects to begin construction in the third quarter of 2005, and the project has a total estimated investment of approximately $145 million. The Company has incurred aggregate costs of approximately $89 million on all of these projects as of March 31, 2005, and currently projects it could spend approximately $40 million of the remaining $148 million of presently budgeted development costs during the remainder of 2005, depending on leasing activity. In addition, the Company had a development project and a redevelopment project that were added to the Company’s stabilized portfolio in 2003 and 2005, respectively, which had not yet reached stabilized occupancy as of March 31, 2005. Depending on leasing activity, the Company currently projects it could spend approximately $10 million for these projects during the remainder of 2005. See additional information regarding the Company’s in-process development and redevelopment portfolio under the caption “Development and Redevelopment.”
As of March 31, 2005, the Company had executed leases that committed the Company to $18 million in unpaid leasing costs and tenant improvements and the Company had contracts outstanding for approximately $1 million in capital improvements at March 31, 2005. In addition, during the remainder of 2005, the Company plans to spend approximately $9 million to $13 million in capital improvements, tenant improvements, and leasing costs for properties within the Company’s stabilized portfolio, depending on leasing activity. Capital expenditures may fluctuate in any given period subject to the nature, extent and timing of improvements required to maintain the Company’s properties. Tenant improvements and leasing costs may also fluctuate in any given period depending upon factors such as the type of property, the term of the lease, the type of lease, the involvement of external leasing agents and overall market conditions.
Other Liquidity Needs
The Company is required to distribute 90% of its REIT taxable income (excluding capital gains) on an annual basis in order to qualify as a REIT for federal income tax purposes. Accordingly, the Company intends to continue to make, but has not contractually bound itself to make, regular quarterly distributions to common stockholders and common unitholders from cash flow from operating activities. All distributions are at the discretion of the Board of Directors. The Company may be required to use borrowings under the Credit Facility, if necessary, to meet REIT distribution requirements and maintain its REIT status. The Company has historically distributed amounts in excess of its taxable income resulting in a return of capital to its stockholders, and currently has the ability to not increase its distributions to meet its REIT requirements for 2005. The Company considers market factors and Company performance in addition to REIT requirements in determining its distribution levels. Amounts accumulated for distribution to shareholders are invested primarily in interest-bearing accounts and short-term interest-bearing securities, which are consistent with the Company’s intention to maintain its qualification as a REIT. Such investments may include, for example, obligations of the Government
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National Mortgage Association, other governmental agency securities, certificates of deposit and interest-bearing bank deposits. On March 9, 2005, the Company declared a regular quarterly cash dividend of $0.51 per common share, which was paid on April 15, 2005 to stockholders of record on March 31, 2005. This dividend is equivalent to an annual rate of $2.04 per share. In addition the Company is required to make quarterly distributions to its Series A Preferred unitholders and Series E and Series F Preferred Stockholders, which in aggregate total approximately $15 million of annualized preferred dividends and distributions.
The Company’s Board of Directors has approved a share repurchase program, pursuant to which the Company is authorized to repurchase up to an aggregate of four million shares of its outstanding common stock. An aggregate of 1,227,500 shares currently remain eligible for repurchase under this program. The Company may opt to repurchase shares of its common stock in the future depending upon market conditions. The Company did not repurchase shares of common stock under this program during the three months ended March 31, 2005.
The Company believes that it will have sufficient capital resources to satisfy its liquidity needs over the next twelve-month period. The Company expects to meet its short-term liquidity needs, which may include principal repayments of its debt obligations, capital expenditures and distributions to common and preferred stockholders and unitholders, through retained cash flow from operations and borrowings under the Credit Facility.
The Company expects to meet its long-term liquidity requirements, which may include property and undeveloped land acquisitions and additional future development and redevelopment activity, through retained cash flow, borrowings under the Credit Facility, additional long-term secured and unsecured borrowings, dispositions of non-strategic assets, issuance of common or preferred units of the Operating Partnership, and the potential issuance of debt or equity securities of the Company. The Company does not intend to reserve funds to retire existing debt upon maturity. The Company presently expects to refinance such debt at maturity or retire such debt through the issuance of equity securities, as market conditions permit.
Off Balance Sheet Arrangements
As of March 31, 2005, the Company did not have any off-balance sheet transactions, arrangements or obligations, including contingent liabilities.
Historical Cash Flows
The principal sources of funding for development, redevelopment, acquisitions and capital expenditures are cash flow from operating activities, the Credit Facility, secured and unsecured debt financing and proceeds from the Company’s dispositions. The Company’s net cash provided by operating activities increased $3.5 million, or 18.6%, to $22.3 million for the three months ended March 31, 2005 compared to the $18.8 million for the three months ended March 31, 2004. The increase is primarily attributable to an increase in average occupancy in the Core Office Portfolio. For the three months ended March 31, 2005, average occupancy in this portfolio was 94.6% as compared to 89.0% for the three months ended March 31, 2004.
Net cash provided by investing activities increased $30.5 million, or 320.8%, to $21.0 million net cash provided by investing activities for the three months ended March 31, 2005 compared to $9.5 million net cash used in investing activities for the three months ended March 31, 2004. The increase was primarily attributable to the disposition of four buildings in March 2005 (see Note 2 to the Company’s consolidated financial statements for further discussion of the dispositions).
Net cash used in financing activities increased $24.5 million, or 197.4%, to $37.0 million for the three months ended March 31, 2005 compared to $12.5 million for the three months ended March 31, 2004. This increase was primarily attributable to a $23.9 million increase in net repayments on the Company’s debt for the three months ended March 31, 2005 compared to the three months ended March 31, 2004, resulting from the repayment of borrowings under the Credit Facility with the net proceeds from the March 2005 dispositions.
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Non-GAAP Supplemental Financial Measure: Funds From Operations
Management believes that Funds From Operations (“FFO”) is a useful supplemental measure of the Company’s operating performance. The Company computes FFO in accordance with the White Paper on FFO approved by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). The White Paper defines FFO as net income or loss computed in accordance with generally accepted accounting principles (“GAAP”), excluding extraordinary items, as defined by GAAP, and gains and losses from sales of depreciable operating property, plus real estate related depreciation and amortization (excluding amortization of deferred financing costs and depreciation of non-real estate assets), and after adjustment for unconsolidated partnerships and joint ventures. Other REITs may use different methodologies for calculating FFO, and accordingly, the Company’s FFO may not be comparable to other REITs.
Because FFO excludes depreciation and amortization, gains and losses from property dispositions and extraordinary items, it provides a performance measure that, when compared year over year, reflects the impact to operations from trends in occupancy rates, rental rates, operating costs, development activities, general and administrative expenses and interest costs, providing perspective on operating performance not immediately apparent from net income. In addition, management believes that FFO provides useful information to the investment community about the Company’s operating performance when compared to other REITs since FFO is generally recognized as the industry standard for reporting the operations of REITs.
However, FFO should not be viewed as an alternative measure of the Company’s operating performance since it does not reflect either depreciation and amortization costs or the level of capital expenditures and leasing costs necessary to maintain the operating performance of the Company’s properties, which are significant economic costs and could materially impact the Company’s results from operations.
The following table reconciles the Company’s FFO to the Company’s GAAP net income available for common stockholders for the three months ended March 31, 2005 and 2004.
Adjustments:
Net gain on dispositions of operating properties
Funds From Operations(1)
Inflation
The majority of the Company’s tenant leases require tenants to pay most operating expenses, including real estate taxes, utilities, insurance and increases in common area maintenance expenses, which reduces the Company’s exposure to increases in costs and operating expenses resulting from inflation.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary market risk faced by the Company is interest rate risk. The Company mitigates this risk by maintaining prudent amounts of leverage, minimizing capital costs and interest expense while continuously evaluating all available debt and equity resources and following established risk management policies and procedures, which include the periodic use of derivatives. The Company’s primary strategy in entering into derivative contracts is to minimize the variability that changes in interest rates could have on its future cash flows. The Company generally employs derivative instruments that effectively convert a portion of its variable-rate debt to fixed-rate debt. The Company does not enter into derivative instruments for speculative purposes.
Information about the Company’s changes in interest rate risk exposures from December 31, 2004 to March 31, 2005 is incorporated into this Item 3 by reference to “Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources”.
Tabular Presentation of Market Risk
The tabular presentation below provides information about the Company’s interest-rate sensitive financial and derivative instruments at March 31, 2005 and December 31, 2004. All of the Company’s interest-rate sensitive financial and derivative instruments are held for purposes other than trading. For debt obligations, the table presents principal cash flows and related weighted average interest rates or the interest rate index by contractual maturity dates. The interest rate spreads on the Company’s variable-rate debt ranged from LIBOR plus 1.10% to LIBOR plus 1.20% at March 31, 2005 and were LIBOR plus 1.10% at December 31, 2004. For the interest-rate swap agreements, the table presents the aggregate notional amount and weighted average interest rates or strike rates by contractual maturity date. The notional amounts are used solely to calculate the contractual cash flow to be received under the contract and do not reflect outstanding principal balances at March 31, 2005 and December 31, 2004. The table also presents comparative summarized information for financial and derivative instruments held at December 31, 2004.
Interest Rate Risk Analysis—Tabular Presentation
($ in millions)
Liabilities:
Unsecured debt:
Variable-rate index
Fixed-rate
Average interest rate
Secured debt:
Interest Rate Derivatives Used to Hedge Variable-Rate Debt:
Interest-rate swap agreements:
Notional amount
Fixed-pay interest rate
Variable receive rate index
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ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its reports under the Securities Exchange Act of 1934 is processed, recorded, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, the Chief Executive Officer and Chief Financial Officer concluded, as of that time, that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
There was no change in the Company’s internal control over financial reporting that occurred during the three months ended March 31, 2005 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting. The Company may make changes in its internal control processes from time to time in the future.
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ITEM 1. LEGAL PROCEEDINGS
In January 2005, the Company settled its previously disclosed litigation with EBC I, formerly known as eToys, Inc.
Other than ordinary routine litigation incidental to the business, the Company is not a party to, and its properties are not subject to, any legal proceedings which if determined adversely to the Company, would have a material adverse effect upon the financial condition, results of operations and cash flows of the Company.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the three months ended March 31, 2005, the Company redeemed 269,249 common limited partnership units of the Operating Partnership in exchange for shares of the Company’s common stock on a one-for-one basis. The 269,249 common shares issued in connection with these redemptions were issued pursuant to an effective registration statement.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES—None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS—None
ITEM 5. OTHER INFORMATION—None
ITEM 6. EXHIBITS
Description
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
Section 1350 Certification of Chief Executive Officer
Section 1350 Certification of Chief Financial Officer
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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on April 27, 2005.
By:
/S/ JOHN B. KILROY, JR.
/S/ RICHARD E. MORANJR.
Richard E. Moran Jr.
Executive Vice President and Chief Financial Officer (Principal Financial Officer)
/S/ ANN MARIEWHITNEY
Ann Marie Whitney
Senior Vice President and Controller(Principal Accounting Officer)
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